Straight and Level

Practical Airline Economics

Stephen Holloway

• Publisher: Routledge
• Year: 2017
• ISBN:
  9781351774215
• Edition: 1
• Topic: Betriebswirtschaft
• Subtopic: Business allgemein

This title was first published in 2003.Airline operating profits are well known to be volatile, and the global industry aggregate figures conceal wide differences in performance between carriers. The fundamental reasons for the poor performance of the industry as a whole were in the early 1990's that output ran too far ahead of demand, and the yield earned on output sold was insufficient to cover costs. In strategic context, this second edition uses a simple yet powerful model to explore linkages between the fundamentals of airline economics and the volatility of industry results at the operating level. Its five parts look in turn at strategic context, supply side, demand side, network management and a general conclusion.

Part 1
Strategic Context

One point of view is that industry economics are our master, determining what can and cannot be done. Less deterministically, we can take the view that an understanding of industry economics is a tool which allows managers to work towards the vision they have for their airline's future and to meet the more explicit objectives established by stakeholders such as customers, employees, alliance partners, shareholders, and members of the wider community. This book takes the latter approach. The single chapter in the opening part of the book outlines a customer-oriented strategic framework within which the understanding of industry economics developed in subsequent chapters can be applied. Holloway (2002) provides a more comprehensive treatment of the themes introduced in the first chapter, and is in many respects complementary to the present book.

1 Economics and Strategy

Two balloonists, after drifting for days in stormy weather, saw a house.
They descended over it and noticed a man who came out to see what they wanted.
'Where are we?', they asked, 'In a balloon', replied the man.
'He must be an economist', remarked one of the balloonists.
'Totally rigorous and utterly useless.'
Apocryphal story quoted in Varoufakis

(1998: 370)

Chapter overview

Most airlines have a competitive strategy embodying the type of value they intend delivering to targeted customers. This choice of competitive strategy is reflected in each carrier's operating strategy. The performance associated with any operating strategy is driven by the revenues earned from delivering expected benefits to targeted customers and the costs incurred delivering those benefits. Part 2 of the book will look at airline revenues (traffic x yield) and costs (output × unit cost). Part 3 will focus on key aspects of capacity management, which is in many respects the critical operations management challenge because it lies at the interface between cost and revenue streams. Part 4 looks at several key macro-level metrics of operating performance. What this opening chapter does is outline the strategic context within which costs and revenues are generated. It begins by making the point that although economists have made major contributions to the study of both organizations and their strategies, they do not provide the only valid perspective on either.

i. Alternative perspectives on the nature of organizations

Consider how three different baseball umpires might call balls and strikes.

• Umpire 1 'I call them as they are.' (i.e., They are 'out there' and I observe them.)
• Umpire 2 'I call them as I see them.' (i.e., I construct reality by interpreting what I perceive.)
• Umpire 3 'They're nothing until I call them,' (i.e., Balls and strikes are not real things, just labels applied to give meaning to passing baseballs.)

These explanations are respectively representative of the positivist/modernist, interpretivist/constructivist, and postmodern paradigms which frame the worldviews of academic researchers and managers. Economics is an overwhelmingly positivist/modemist discipline. Reducing to numbers all the most critical variables used to understand and manage an airline, or indeed any other organization, is not without its dangers, however.

The purpose here is not to judge this debate, but to stress that although the present book adopts the positivist leanings common to most economics texts, the fact that there are alternative ways of looking at organizations and how they behave needs to be borne in mind. This can be seen particularly clearly in three topics that lie at the heart of organization studies: external environments, objectives, and decision-making processes. We will look briefly at each of these.

Representing the external environment

From a positivist/modernist perspective, the environment exists and can be observed - perhaps by breaking it down into its constituent elements, as when a strategic planner conducts a PEST analysis (of an organization's political, economic, social, and technological environments) or a network theorist identifies external actors in the networks within which each organization is embedded. The environment lies outside the boundaries of the organization (itself a definable 'thing'), and imposes: demands (e.g., for specific types of adaptive behaviour as the 'price' for survival); and uncertainty (e.g., the unpredictability of future environmental demands).

The environment as seen from an interpretivist perspective, on the other hand, imposes itself on organizations Jess through the 'real' impact of 'real' events than through the interpretations people place on what they perceive to be happening. For example, one manager's threat is another's opportunity. Neither the environment nor its supposed constituent elements are objective facts; pressures, influences, complexity, change, instability, turbulence, and other 'qualities' are in the eye - or, more correctly, the mind of the beholder. In other words, it is people who are uncertain, not environments. From this perspective, environments do not control people or organizations by enforcing certain types of response, as positivists might argue; instead, what happens is that people construct images of their environments and then respond to those images as though they were a controlling influence. A back-firing car does not make a passer-by jump or duck, but that person's image of a bullet or a bomb certainly might. Interpretivist theories of organization-environment relations have been slower developing and less influential overall than positivist/modernist theories.

Finally, many postmodernists would argue that the distinction between organization and environment is the child not of reality, but of the use of language such as 'internal', 'boundary', and 'external'. Similarly the growing use of new concepts invoking recognition of 'virtual', 'network', or 'boundary-less' organizations is less a reflection of the sudden appearance of these new forms than a comment on the power of language to use metaphors in the construction of 'reality'. Whilst postmodernist concerns with issues such as environmental sustainability, ethics, and social responsibility have begun to introduce themselves into discourse on organization-environment relations, their impact on mainstream debate and theorising in the field has been limited.

Does any of this matter in practice? If we bear in mind that several generations of airline managers have been schooled in the use of strategic management techniques designed to 'fit' their (unitary) organizations to their (objectively identifiable) external environments, the answer is that it probably does.

Organizational objectives

Although conflict and political processes are not ignored, the 'organization-as-individual' metaphor - the notion that each organization acts in a unitary way as though it were a single individual with rationally chosen and clearly articulated objectives - is implicit in much of the academic literature and most college-level textbooks (particularly economics textbooks). In practice, each organization is influenced by external and internal stakeholders who have different expectations about its performance - about what it should achieve; different expectations about performance will often mask different assumptions with regard to purpose. Despite the fact that most people working inside airlines and other organizations are well aware of this, the 'orgamzation-as-individual' metaphor remains pervasive. Indeed, neoclassical microeconomics assumes that each firm - whether a sole trader or a global corporation - has only a single objective function, almost invariably profit maximisation.

Profit maximisation is not an unproblematic purpose, however.

1. As an espoused objective, it has flaws.
   • There is no way of knowing whether profit has 'really' been maximised. As we will see, economics gives us marginal analysis to help maximise profits by continuing to produce output until marginal revenue equates exactly to marginal cost. Fine in theory, nobody has yet figured out to everybody else's satisfaction how to measure (as opposed to how to define) marginal revenue or marginal cost in highly complex and dynamic multi-product organizations (rather than simple textbook examples).
   • Steps taken to maximise short-run profits (e.g., trimming the current advertising or training budget) might damage long-run profits (e.g., by weakening the brand).
   • Accounting practices, particularly in respect of aircraft depreciation and the recognition of foreign exchange gains and losses, make attainment of earnings per share and other profit objectives as much a matter of opinion as of fact (something that cash flow-based shareholder value metrics are now addressing).
2. The chosen route to profit maximisation can be as important as the objective itself. Many airlines (e.g., American and United in the 1980s) have pursued growth in market share on the mistaken assumption that dominant share inevitably brings with it pricing power and higher earnings (Damodaran, 2001).
3. There are viable alternatives even within economics to the neoclassical assumption that profit maximisation is the sole objective function.
   • Simon (1960) and Cyert and March (1963) argued that objectives arise not from rational planning but out of negotiations between shifting coalitions.
   • Baumol (1959) proposed a model based on revenue-maximisation subject to a 'minimum profit' constraint. The argument is that external and internal stakeholders pay more attention to - and reward - steady sales growth (subject to earnings above some minimum level) than to inherently less stable earnings gyrations.
4. There is an influential stream within the recently developed sendees management literature that characterises profit not as an objective to be maximised, but as a by-product of the satisfaction and loyalty of both employees and customers (Heskett et al, 1994; Holloway, 2002).
5. Airlines, like most other organizations, are socially complex phenomena comprised of individuals who either singly or in a coalition with others might be willing superficially to accept profit maximisation or shareholder value enhancement as a dominant purpose, but whose real agendas are likely to have several other items of business on them. Some economists refer to this as the 'maximisation of managerial utility', arguing that managers pursue their own personal objectives (e.g., compensation, power, aggrandisement) but subject to some minimum profit sufficient to keep shareholders and analysts satisfied.

The dominant paradigm in textbooks and amongst practitioners nonetheless makes a fundamental assumption that organizations are unitary entities, inevitably goal-seeking, and driven fundamentally by pursuit of profit. An alternative view is that behaviour has at least as much to do with individual and group survival and betterment as with pursuit of espoused organizational objectives. It is fair to say that whilst economic considerations are rarely unimportant, neither are they always the sole driving force behind action and performance.

Organizational decision-making

Managerial decision-making can be studied from either a prescriptive or descriptive perspective (Bazerman, 1998). Prescriptive approaches try to establish how decisions should be made; they are often referred to as 'rational choice' models, and both economics and quantitative decision sciences fall into this camp. Descriptive approaches examine not how decisions should be made, but how in practice they are made. The message, again, is that economics is not the only discipline with views on the matter.

Economists generally see economic action as:

• arising from the application of rational choice models to decisions regarding the allocation of resources that are scarce and have alternative uses (and therefore carry opportunity costs);
• being driven by a hierarchy of preferences held by utility-maximising individuals, households, and firms; and
• starting and ending at points of equilibrium (although there are traditions within economics away from the neoclassical mainstream - one of which, 'evolutionary economics', we will meet shortly - that see competition as dynamic and disequilibrating).

Economists holding these perspectives broadly take the view that market mechanisms are the preferred means through which to allocate resources, and they assume in most cases that market participants carry no histories (personal, organizational, cultural or political) into the making of rational, goal-oriented decisions. Mainstream neoclassical microeconomics pays no attention to the impact of social relations and social structures on production, distribution, or consumption.

Sociologists, on the other hand, tend to see economic acts as socially constructed, because economic action is just one part of a much broader flow of social relations between individual actors both inside and outside organizations. Apparently rational economic decisions might be taken, for example, as a result of considerations which do not figure in the supposedly acontextual models that economists like to argue are universal in their application. A seminal contribution from Granovetter (1985) argued that economic decision-making must be looked at not in isolation, but as purposive action that is embedded in ongoing systems of social relations.

As with much else in this chapter, we will hear echoes of these ideas later in the book.

Conclusion

Neither economics nor any other discipline has comprehensive insight into all organizational problems; each has only partial insight into what is a complex social reality. However, the more that the solution to a given problem turns upon arriving at an optimal allocation of scarce resources, the greater the contribution that economic approaches to understanding organizations can make. Many strategic decisions essentially address resource allocation problems; the next section looks at the relationship between economics and strategy.

ii. Economics and strategy

If there is active debate about the nature of organizations and the manner in which we should treat their environments, objectives, and decision-making processes, there is also active debate in the field which tries to explain why firms exist and behave in the ways they do and why some outperform others. This field - variously referred to as strategy, strategic management or business policy - is covered in detail by a large number of texts. The purpose of the present section is to briefly contextualise the field and highlight the contribution of economics, so laying the foundations for consideration of competitive strategy and customer value later in the chapter.

What is a strategy?

There are several possible answers to this seemingly simple question.

• Strategy as a plan Until relatively recently, strategy has been thought of as just another type of plan, albeit a significant variety of the species. This is a positivist/modernist standpoint which peddles images of top managers marshalling the resources of an inherently controllable organization so that it can plot a determinate course through a knowable, albeit perhaps uncertain, environment. The reified...

Table of contents

• Cover
• Half Title
• Dedication
• Title
• Copyright
• Contents
• Figures and Tables
• Foreword by Maurice Flanagan
• Preface
• Acknowledgements
• Abbreviations and Definitions
• Part 1: Strategic Context
• Part 2: Operating Performance Drivers
• Part 3: Capacity Management
• Part 4: Operating Performance
• References
• Index